Feeling Parched

I have spent much of the summer in Iowa, in the heart of the new dust bowl, so implications of the drought are on the top of my mind at the moment. And last night I visited the Iowa State Fair, one of those all-American events that is a combination trade show, entertainment festival and the ultimate food court. There is no better place to take the pulse of the "on the ground" players in the industry.

Some of the investment implications of the drought are obvious. Commodity prices are going higher, especially for corn which has been hit the hardest, so look for unexpected input cost inflation at the major processed food players such as ConAgra (CAG) and Kellogg (K). Those companies typically have pricing power and will take action in the near term, but the softening economy may not allow a full pass-through as normal.

Some implications are less obvious. Farmers know that higher grain prices are on the way, which means feed costs for livestock are going up as well. Farmers will react rationally and accelerate the culling of the herd. They will sell more livestock sooner, increasing the slaughter rate this fall. The counterintuitive result will be downward pressure on protein prices as beef and pork supplies increase. Look for this phenomenon to affect the major protein names such as a Tyson (TSN).

An the insurance industry grew up in the Midwest to protect farmers from these sorts of risks, so regional players may see heightened claims activity. There are no pure-play crop insurance names to my knowledge, but do your research for second-order effects on reinsurers or Des Moines-based insurers such as EMC Holdings (EMCI), or perhaps in bond issues for larger Midwestern-based names such as State Farm.

The ethanol industry uses up to one-third of the annual corn crop, and spreads between ethanol market prices and input costs are getting squeezed terribly. Pure plays including Green Plains Renewable Energy (GPRE) or Biofuel Energy (BIOF) have been decimated -- the latter is down 80%, year-to-date. The pressure on these businesses now is real; however, these are highly cyclical businesses. The supply response in agriculture is rapid, and higher prices will incent a record planting next year. Barring another year of drought, which is always a risk, there could be a bumper corn crop next year, with resulting lower prices. The spread relief would do wonders for the GPREs of the world. Those with a strong stomach should place their bets now, when the blood is running in the streets. Sometimes when things are really bad, they can only get better.